Last year I saw Win Win, a movie starring Paul Giamatti, Amy Ryan and Jeffrey Tambor. The movie, besides receiving critical acclaim, had two hooks for me. One, the protagonist in the movie is an attorney. I am a sucker for almost any lawyer movie. (I still say My Cousin Vinny is one of the best 50 movies of the past 50 years.) And two, the movie included wrestling. No, not the Hulk Hogan and Macho Man Randy Savage stuff. I mean the real folkstyle wrestling that occurs every 4 years at the Olympics and at the collegiate level.
My dad was a college wrestler, which is probably why I have come to appreciate the sport. Anyway, without giving away too much, the movie basically sets up a scenario whereby Paul Giamatti's character is able to have his cake and eat it too, at least for a little while. In a recent decision out of the United States Court of Appeals for the Third Circuit, the Court allowed property owners to achieve this oft mentioned but rarely achieved result, holding, to the chagrin of the Internal Revenue Service, that the installment interest the property owners received as part of a settlement agreement with the government could be excluded from taxable income. DeNaples v. IRS (4th Cir. March 19, 2012).
In 1998, as part of a highway improvement project, the Pennsylvania Department of Transportation filed an eminent domain proceeding seeking to condemn several parcels of real property. In 2001, the property owners agreed that in exchange for all of their ownership interest in the various parcels, the Department of Transportation would pay $40.9 million, of which $24.6 million would be allocated to principal and $16.3 million would be allocated to interest ("settlement interest"). A few months later, however, when the parties executed the formal settlement agreement, the State lacked the necessary funds to pay the lump sum of $40.9 million. In order to accommodate the State's fiscal situation, the property owners agreed to accept the settlement funds in five installment payments subject to the interest rate set forth in the Pennsylvania Rules of Civil Procedure ("installment interest").
The State made timely payments, but the property owners filed income tax returns each year that identified only some of the settlement funds. Specifically, the property owners excluded from their gross income a portion of the settlement interest income and all of the installment interest income. In 2008, the IRS issued a deficiency notice asserting that the property owners owned an additional $2.3 million in taxes.
During the litigation before the Tax Court, the property owners argued that under Section 103(a) of the Internal Revenue Code, the excluded interest income and installment income were not subject to taxation because they were an "obligation of the State." Section 103(a) states, in part, that "gross income does not include interest on any State or local bond." The Tax Court rejected the argument, and the property owners appealed.
On appeal, the Third Circuit explained:
when the state pays interest at a fixed rate pursuant to a statutory or judicial command, it is plainly not excludable under Section 103 of the Internal Revenue Code. On the other hand, when the government's obligation to pay interest arises out of voluntary bargaining, the interest exclusion may play an important role in allowing the state to reduce its borrowing costs. This implicates the state's borrowing authority and may be excludable under Section 103.
Turning to the merits of the case, the Third Circuit found that the installment interest was the result of voluntary bargaining, not by operation of law, since it did not necessarily spring from the settlement of the eminent domain action. In this regard, the Court noted that it was critical that no condemnation award was ever issued, and that the installment interest rate was lower than what the property owners would have been entitled to if the condemnation proceeding had been completed.
The Fourth Circuit did issue a warning, however, stating that it was not holding that any interest payment made pursuant to a voluntary settlement agreement is automatically excludable under Section 103. Also, the Fourth Circuit held that the settlement interest was taxable, because the property owners failed to demonstrate why their initial allocation between interest income and principal was not arbitrary and excessive.
Thus, the property owners scored a Win Win, at least with respect to the installment income.